Posted on: April 13, 2020 Posted by: Maira Asaad Comments: 0

by Waleed Iqbal

The very first case of coronavirus (COVID-19) was identified in December 2019 in the city of Wuhan, China and since then it has transformed into a global pandemic. With the number of cases surpassing 400,000 and more than 15,000 deaths worldwide, coronavirus has now affected 192 countries. Due to its contagious nature, minimal public interaction is needed to prevent further spread. Therefore, nations around the globe are implementing lockdowns with spillover effects on economic activities across the globe.

Both developing and developed countries are more or less equally affected and financial markets are reflecting the damage done by the ongoing crisis. The stock market, a leading indicator of economic activity in various countries, has witnessed unprecedented crashes. Dow Jones Industrial Average, a dominant index in the United States, has lost more than 29% of its value since the virus was visible in the region. Consequently, in an attempt to stimulate economic growth, The Fed (Federal Reserve System in USA) has reduced the interest rate to almost zero. A similar scenario has been observed in European markets where FTSE (Financial Times Stock Exchange) index took a plunge of more than 24% and the Bank of England policed the policy rate to an all-time low of 0.1%. Developing markets, especially those in the Subcontinent, saw a more interesting happening. India, the second most populous country in the world, saw the BSE Sensex Index decline by more than 19%. Yet, the Reserve Bank of India is indecisive with regards to revising its monetary policy. As far as Pakistan is concerned PSX lost more than 27% of its value whereas State Bank of Pakistan’s policy rate stood at a double-digit figure of 11% after being slashed by 225 basis points.[1] 

It is globally evident that economies are experiencing a slump, although their responses to it differ considerably. Predominantly, it boils down to whether interest rate cuts will offset the tumble in economic activity caused by lockdowns. While the primary rationale behind an interest rate cut is to raise the current bar of consumption through lowered cost of borrowing and thereby extending purchasing power; it is vital to consider whether reduced purchasing power has mainly contributed to the current recession. It is not reduced purchasing power that is submerging economies but the inability of the public at large to conduct their economic affairs. The availability of funds at a negligible cost of borrowing would not result in a significant impact on the wider economy, as people are physically restricted from spending. Not only will this have an insignificant effect on the consumption of consumer goods, but the injection of capital goods into the economy will also be fairly limited. Given the prevailing uncertainty pertaining to halted production, investors are reluctant to expand their stake. Therefore, the anticipated impact of the interest rate cut may not be materialized.

Moreover, slashing interest rates abnormally, as witnessed in developed economies, largely drives ‘hot money’ out of the economy.[2] But, as interest rates in such economies are inherently stable and low, it is not much of a concern for them as they are able to withstand it. However, in the case of developing countries where interest rates are relatively higher, lowering them could cause a considerable outflow of ‘hot money’, thereby potentially destabilizing the economy.  

Two days ago, the IMF (International Monetary Fund) announced to temporarily suspend the  debt repayments for developing nations. This may suggest arguing for interest rate cuts. However, the recent cuts have come at a cost of massive currency devaluation. For example, the 1.5% decrease in interest rate led to USD jumping to PKR 168, the highest ever. The British pound also climbed by 20 rupees in three days, despite maintaining a stable level earlier. In the last few weeks, this fluctuation has caused an overall plunge of 1490 million USD in the State Bank’s reserve level.. This, alongside the steep import bill, makes the downsides of searing interest rates far greater for developing countries than the advantage associated with limited rise in consumption.[3] It is worth mentioning though that the only considerable positivity with reduced policy rate could be observed in the health sector, if funds secured are channelized to upgrade the current healthcare system at large. 

Therefore, slashing interest rates abnormally is nothing but to target the symptoms and not the causes.

Maira Asaad

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